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Tuesday, September 8, 2015

Startup investors are changing their focus from Gross Merchandise Value to profitability

Up until recently, the ability to raise cheap money at unprecedentedly high valuations was the strongest force shaping business strategy

The tide has turned. A co-founder at one of India's top three e-commerce firms sums up the sharp change in investor approach in one sentence: "My KRA has changed from Gross Merchandise Value (GMV) to profitable orders."

This is the new reality for e-commerce firms that have together raised about $11 billion (Rs 73,000 crore) from venture capitalists over the past four years. The days of easy money at soaring valuations are over.

"Telling investors that there's plenty of headroom for growth no longer catalyses valuation. They want less discounts and more cash," the co-founder mentioned earlier adds.

He and other founders and CEOs at India's e-commerce firms now have to quickly reorient business strategy to suit new realities.

Up until recently, the ability to raise cheap money at unprecedentedly high valuations was the strongest force shaping business strategy.

Companies were willing and able to take losses - in the form of relentless discounting of products - to build customer base. Now, investors are demanding these firms show a clear path to profitability as the cost of customer acquisition remains high.

"Growth of valuations has come down and expectations to show profits have gone up," says Vijay Shekhar Sharma, founder, Paytm. He knows the implications of this quite well. "Valuations and spending have a linear relation - lower valuation equals lower spending and vice versa."Time for a Reality Check

It's not limited to just the Unicorns (startups with over $1 billion in valuation); the tremors are threatening smaller firms even more.

"Cash is no longer free flowing and this will make businesses real," says Yashish Dahiya, founder, PolicyBazaar.com. "The environment has tightened in the past six months."This is a remarkable shift in a fairly short period. "Focus is now on capital efficiency rather than burning cash," says K Ganesh, serial entrepreneur and investor. "If a year back, investors were willing to let startups burn $50 million for one year just to acquire customers, they are reducing both the money and window to acquire customers to three to six months."

He points to startups like food delivery apps that were virtually giving away money for people to eat. They did this to show more transactions and boost valuations. "Investors are now unwilling to give out free meals for too long. They want the window of discounting to reduce and profits to show up," he adds.

Marketing expenditure as a percentage of revenue touched a high of 22% last year and is now down to 18%. Says Sandeep Aggarwal, founder, Droom & ShopClues.com, "Ideally marketing spends should be in single digits as in the developed markets. India is growing and competition is intense, but to be profitable companies have to check wasteful spends and directionally it's coming down."

Besides, Aggarwal points out that companies are negotiating hard with vendors - logistics and payment gateway providers. "Logistics costs have come down by 15-20% in the past one year and companies negotiate hard with payment gateway providers - cutting commissions on credit card or net banking payments," he adds.

Adds Aggarwal, "Hiring has shifted from 'nice to have' to 'must have'. Earlier companies didn't bother about say, extra 30-40 people in a division, now they are asking whether they really need them."

Some startups are reportedly considering increasing the number of working days from five to six as companies look to extract more output per employee.

Says the head of a Bengaluru-based human resource consulting firm that hires for Internet companies, "Lots of executives joined from large multinationals and in some cases even NRIs returned from the US (like Google veteran Punit Soni who joined Flipkart) to join startups. But they find things are not that rosy - working hours are stretched and expats are asking questions about quality of work-life."

Compensation and Esops are also coming under scrutiny. "Valuations behave like optics for new hires. Higher valuations result in better Esops," says Paytm's Sharma. But lower valuations now are impacting Esops.

"Valuations do impact Esops," adds Shiv Agarwal, CEO, ABC Consultants, a recruitment firm. For the same level (say vice president) if a year back it was Rs 2 crore (offered in Esops), that's now Rs 1.5 crore.

"E-commerce is here to stay, but it's a highly risky business as we don't know which startups or even late stage companies will succeed," he adds. There is no pullback yet on hiring. In fact, e-commerce firms are pressing ahead with the coming festive season in mind. The next four festive months generally account for 40% of total annual sales.

"There's no drastic cut as yet on hiring, and some skills like CTO do carry a premium," says Agarwal. "The fizz and hoopla around businesses has got diluted and investors are asking for real money," he cautions. Companies are also likely to cut marketing expenditure and temper discounting of products as raising cheap capital has become harder.

Last festive season (October-December 2014), online marketplaces together offered discounts up to $800 million, industry sources estimate. "This festive season, it will be 30% to 40% less as focus shifts from GMV to unit economics," says the marketing head of one of the top five ecommerce companies who did not want to be named.

Too much discounting is being seen as too risky. Taxi For Sure (TFS) offered cab rides at Rs 49 and eventually had to sell out to rival Ola, says an investor who wished not to be named. "There's lot of bargaining. Startup founders defend discounting as customer acquisition costs and point to future growth. Investors want hard numbers and don't buy into all future projections."

Few saw this squeeze coming even though there were signs. For instance, in February, online marketplace Snapdeal was in talks with investors to raise $400 million at a valuation of $5 billion.

The deal didn't happen because investors were unwilling to invest at that valuation. Almost six months later, on August 19, Alibaba, Foxconn and SoftBank injected $500 million at a valuation of $4 billion to $4.5 billion, lower than what Snapdeal founders were initially looking for. Snapdeal declined to comment on valuations. Rival Flipkart was valued at $15 billion post its last round of funding in May .

Says Aggarwal of ShopClues, "Alibaba's, the darling of Internet startups, A stock is down 25% from its peak. Besides Nasdaq-listed Makemytrip.com is trading below its IPO price. That impacts sentiment."

Adds Latif Nathani, VP & managing director, eBay India: "Last year, venture investments were more than the size of the e-commerce business. It's hard to characterise this as a bubble as long term opportunity in Internet businesses is significant. But we have seen valuations that give you a second thought." In the early days of Internet businesses, investors pumped in money across startups, to ensure they don't miss out on tomorrow's star.

The promises of finding a gold mine at the end of the distant horizon made investors bet on teams and power points rather than a hard, rational look at business plans. This so-called 'FOMO' effect (Fear of Missing Out) that triggered the valuations frenzy has almost disappeared.

Says Niren Shah, managing director, Norwest venture Partners: "FOMO (fear of missing out) drove up valuations. That factor is lower now. The market is worried about profitability, but is not yet in steep decline."

Likewise, deciding valuations over drinks based on the founders' credentials, an early-stage investment phenomenon, has sobered down now as investors do deep reality checks.

GMV, or gross merchandise value, has been a proxy for startup valuations as the traditional approach involving earnings multiples do not work for startups with no profitability. But investors are changing their mindset now, seeking out unit economics rather than go by GMV alone. Indeed, GMV multiples in India - between three and four times - were higher than mature markets, like the US and Europe, where it's less than one.

"Investors are looking for positive unit economics," says Shah of Norwest Venture Partners. "Competition is intense and startups give discounts to attract buyers. But the more discount you give, the worse will be the unit economics."

So for smartphones, where margins are less than 5%, discounts and free home delivery eat into the margins, making the unit economics veer to negative. On products like furniture, it may be positive as margins are better (about 20-25%). Companies can literally buy GMVs by discounting.

Now, with a focus on unit economics, the cash burn is being checked. "Sanity is coming into the system," says Ganesh.Source : http://bit.ly/1UETpoj